Baseline Scenario

The Baseline Scenario
It Takes A Citi
Goldman’s Best Year Ever?
Modeling Everything, Public Plan Edition
It Takes A Citi
Posted: 24 Jun 2009 05:52 PM PDT
Washington-based policy tinkerers seem increasingly drawn to the idea that greater reliance on market information can forestall future problems – e.g., providing input into an early warning system that can be acted upon by a “macroprudential system regulator”. And while leading critics of the administration’s proposed approach to rating agencies make some good points, they also seem to think that the market tells us when big trouble is brewing.
The history of Citigroup’s credit default swap (CDS) spread is not so encouraging.
It’s true that in some instances during the past two years, CDS spreads have indicated pressure points, e.g., within types of lenders or across countries. And if you can tell me how Citi survives going forward with a CDS spread around 450 basis points, I would be grateful.
The people who price CDS obviously have every interest in assessing risk in a hard headed and accurate manner. But Greenspan’s Lament applies to CDS traders just as much as to incentives within mismanaged banks – where in the Citi CDS spread chart do you see the build up of risk through the end of 2006? If anything, the market for default probability was saying that Citi – and by implication the financial system with all its growing subprime vulnerabilities – was becoming less risky.
You can hope that, in the future, the market will not be so generally exuberant, but 400 years of modern financial history begs to differ.
The WSJ gets this right: regulatory capture is not only pervasive, it is by design. But what’s the implication?
All regulators must ultimately fail and, when that happens, markets may well also misprice risk. The question is: When this Twin Failure occurs next time, how much will be on the line?
You cannot design a financial system that is immune to crash – this would be like declaring earthquakes illegal. But in the aftermath of unexpectedly high damage from a serious earthquake, it makes sense to completely overhaul your building code and retrofit vulnerable buildings. In fact, if you largely ignored what the earthquake revealed in terms of structural weakness, wouldn’t that be negligence?
By Simon Johnson

Goldman’s Best Year Ever?
Posted: 23 Jun 2009 07:41 PM PDT
A reader pointed me to this story in The Guardian citing Goldman insiders saying this could be the investment bank’s most profitable year ever.
Staff in London were briefed last week on the banking and securities company’s prospects and told they could look forward to bumper bonuses if, as predicted, it completed its most profitable year ever. Figures next month detailing the firm’s second-quarter earnings are expected to show a further jump in profits.
A couple months back I said that it would be unlikely for the banks to repeat their spectacular first-quarter results in the second quarter, because it depended on fixed-income revenues being even higher than during the peak of the boom. It looks like I was wrong.
Like most things, there are two ways to interpret this. For the optimists, if some of the big banks are making big profits, that gets us back to a normally functioning financial sector sooner and reduces the chance that they will face a panic in the short term. As many people have pointed out, including us, this is basically the Obama Administration’s strategy.
For the pessimists, the phoenix-rising-from-the-ashes profitability of the big banks is a direct result of massive government aid in the form of cheap money, liquidity programs, and let’s not forget the bailout of AIG; it’s also the result of reduced competition resulting from the consolidation of Bear Stearns into JPMorgan, the failure of Lehman, and the weakened state of Citigroup and Bank of America/Merrill. So the government bought a partially healthy banking sector (the big question is what Citi and B of A will report) with public funds, the few winners (Goldman, JPMorgan) are more powerful than ever, and the government is hoping to get an anemic regulatory reform package through Congress in exchange.
By James Kwak

Modeling Everything, Public Plan Edition
Posted: 23 Jun 2009 06:58 PM PDT
Ezra Klein and Paul Krugman are both highlighting Nate Silver’s analysis of campaign contributions and the public health plan option. The quick summary? Campaign contributions matter – in this case, by about nine senators. Mainly I’m impressed and encouraged that people can use publicly-available data to quickly whip together plausible models answering questions that otherwise we would all just pontificate about.
Coincidentally, I was getting my car inspected this morning and picked up an October 2008 copy of New York Magazine in the waiting room, which had an article about . . . Nate Silver. The article includes a picture of the presidential electoral map as Silver predicted on October 8, in which he called every state correctly except Missouri (which, remember, took a few weeks to figure out whom it had voted for). Most of the article is about how the empirical approach to baseball turns out to be useful in other areas, like politics and public policy.
Update: Mark Thoma points out this counterargument by Brendan Nyhan (who long ago wrote a blog with the brother of one of the best developers at my company). Nyhan says “studies have typically found minimal effects of campaign contributions on roll call votes in Congress,” and cites a Journal of Economic Perspectives paper as backup.
OK, Nyhan may be right. But he may not be.
I looked at that paper. First, it cites a stack of papers that support Silver’s view (that campaign contributions do influence policy). (Of course, it’s common to cite the papers you are trying to refute.) Then it describes a logical argument against Silver’s view (”Tullock’s Puzzle”), which makes no sense to me, at least as summarized there. The argument is that campaign contributions are pitifully small given the amounts of money at stake, and so firms cannot possibly see contributions as an investment in policy. For example:
Dairy producers, who since 1996 have had to have subsidies renewed annually, gave $1.3 million in 2000 and received price supports worth almost $1 billion in the Farm Security and Rural Investment Act of 2002.
I dont’ see the puzzle; if I can get $1 billion in subsidies by paying $1.3 million, why would I pay any more? It seems to me that the explanation here has to do with special-interest politics; no other constituency is sufficiently mobilized to fight against dairy producers, so they get their subsidy. Here’s the conceptual argument: “The figures above imply astronomically high rates of return on investments. In a normal market, with such high rates of return, existing donors should want to increase their contributions.” But this assumes that the “investment return” on campaign contributions is a smooth, monotonic (always increasing) function, which seems fundamentally at odds with the way Congress works. But as I said, maybe Tullock did a better job explaining his puzzle.
Finally, they do a regression of “roll call” votes in Congress against campaign contributions and find little influence. But this analysis has serious limitations in the present context.
First, the dependent variable is the aggregate rating of each legislator by the U.S. Chamber of Commerce. (They got similar results using other organizations.) That is, it’s an average of a large number of votes made in the course of a session on a large number of issues. So the finding is that corporate contributions only pull a legislator a couple of points toward the Chamber of Commerce’s positions overall; but that doesn’t mean that on a given issue, he might switch his vote because of one or two large campaign contributors from the affected industry.
Second, it ignores the complexities of the legislative process. On many key issues, there is no roll call. For example, whether the public plan even comes to a meaningful vote will depend on Harry Reid – who may not even want the public plan – and whether he thinks he has the votes. The power of some members of Congress goes well beyond their individual votes.
Third, the data are from 1978-1994. I’m not a student of American politics, but casually reading The New York Times indicates a few changes in politics since 1994: there is more money; there is more money that is not controlled by political parties (weakening bonds to party, which historically explained a lot of votes); and there is more money that gets spent directly on advertising and is not contributed to political campaigns. This last factor could cut either way, but I think it’s fair to assume that if a company gave you $50,000, they are probably also donating to soft-money groups that take the same positions.
So here we have: on the one hand, a quick-and-dirty model on this specific question by a guy without a Ph.D. in anything (I think), which correctly picks the positions of 87 out of 99 senators (but it’s possible that the model would have done just as well without campaign contributions); on the other hand, a guy with a Ph.D. in political science and a research fellowship in health policy at a very good university, citing a paper by three MIT professors that’s more or less on the same general topic, arguing that campaign contributions don’t affect policy.
By James Kwak